Research to develop method for assessing longevity basis risk

The Life & Longevity Markets Association (LLMA) and the Institute and Faculty of Actuaries (IFoA) have set up a research team, to be led by Macquarie University, which will seek to develop a method for assessing the basis risk of longevity risk transfer transactions.
The research team will also have support from the University of Waterloo, Australian National University and Mercer Australia, with Macquarie University taking the lead.

The research will seek to develop a readily applicable methodology which would enable the basis risk associated with longevity risk transfer transactions to be more easily assessed, when the use of population-based mortality indices are a feature of the transaction.

Mortality indices such as these are often used in pension benefits and annuitant liabilities as well as providing actuaries with key data, and as such have featured in index triggered longevity swaps or reinsurance deals.

Understanding the basis risk between transactions based on mortality and longevity indices, versus actual mortality experience, could help to stimulate further use of indices as a mechanism for mortality risk transfer and reinsurance.

The first phase of this project analysed longevity basis risk and led to the development of a methodology that the researches believe can be used to measure longevity basis risk. This is now the second phase and will focus on putting the research work into practice.

Colin Wilson, President-elect of the IFoA, commented; “The IFoA is delighted to be announcing the team to take this next stage of the research forward. Managing longevity risk is a major concern for pension funds and life insurance companies, and the practical application of assessing basis risk will be useful to many in the industry.”

Robert Bugg, Chair of the Longevity Basis Risk Working Group, added; “We were particularly impressed by the robust and detailed ideas presented by Macquarie University and its supporting team. Following the success of phase one – developing a methodology to measure longevity basis risk – we are looking forward to working with this successful team to progress to the next phase.”

Associate Professor Jackie Li, Macquarie University, said; “Increasing life expectancy poses a significant challenge to insurers, pension plan sponsors, and governments. It is of utmost importance to find theoretically sound and also practically feasible approaches to manage longevity risk. In particular, the use of population-based mortality indices has great potential to deal with this risk but the problem of the existence of basis risk remains unsolved.

“Our team is very excited to have the opportunity to take up this project and develop the methodology further for practical applications. With the backing of University of Waterloo, Australian National University, and Mercer Australia, we are confident in our team’s breadth and depth of capabilities to deliver an effective and valid approach to measure and manage longevity basis risk.”

For reinsurance, or indeed ILS, markets understanding the basis risk between indices and actual mortality rates can help the longevity transactions to be priced more efficiently. A methodology for assessing and quantifying basis risk can also help both the sponsoring pension fund, or life insurer, as well as the risk capital providers to understand the true exposures they are ceding or assuming.

It could also help to encourage greater use of indices within longevity swaps or reinsurance transactions, which can provide an effective way for pensions to hedge their longevity exposures.